How foreign IT cos reduce tax liability in India

NEW DELHI: Foreign information technology majors make clever use of transfer-pricing provisions and double taxation treaties to minimise taxes in India, reports John Samuel Raja D

These are differences that are increasingly drawing the inquisitive and corrective eye of the income-tax department. In 2009-10, TCS, the largest home-grown IT company, recorded a net profit per employee of Rs 4.3 lakh. By comparison, Capgemini, a foreign IT firm with operations in India, recorded a net profit per employee of Rs 1.5 lakh -- about one-third of TCS.

The operations of Indian and foreign IT firms are now structured similarly, they fight for the same business, there is parity in their contract pricing and employee salaries, they follow the same tax rules. So, then, why are foreign IT firms reporting profitability numbers that are a fraction of their Indian peers? It's a question the IT department is beginning to evidently ask foreign IT firms with greater frequency -- and extract more tax revenues from them.

It's not just profits per employee. The differences are equally wide on every comparative financial metric: revenue per employee, operating profit margin, net profit margin. This, say tax experts, is the effect of 'transfer pricing' --or how a foreign parent with operations in many countries, including tax havens, prices its transactions with its Indian subsidiary, ostensibly to reduce its overall tax liability.

The basic premise of rules governing such related-party transactions is that the price at which the Indian subsidiary (say, IBM India) provides a service to its parent (say, IBM US) should be similar to what it would have charged a client. Claiming that foreign IT firms don't always invoke this principle of pricing, the IT department is showing the transfer-pricing rules -- introduced in 2001 --to them. Cases of the department asking foreign IT companies to recalculate revenues are increasing. As is the quantum of adjustments on account of transfer pricing.

The overall adjustment figure for all foreign companies operating in India, in both the IT sector and in non-IT sectors, hit a new high of Rs 22,800 crore in 2010-11. Individual numbers for the IT sector are unavailable, but Rohan Phatarphekar, head of transfer pricing at KPMG, estimates that IT and ITES (IT-enabled services) companies accounted for "one-third to half" of these adjustments.

The case for adjustments.

Most Indian subsidiaries of foreign IT companies operate as 'captives' -- that is, they mostly service their parent companies, located in the US and Europe. So, the parent or another subsidiary located in those continents receives orders from clients.

They sub-contract this work to their Indian subsidiaries. At least 90% of the revenues of the Indian subsidiaries of Accenture, Capgemini and IBM were with group companies. The pricing is usually on a 'cost-plus' basis. This means the Indian subsidiary is reimbursed for all costs incurred and a margin.

In effect, this model delinks the price paid by clients in the UK or US and the amount paid to the Indian subsidiary for the work done by it. As a result, while the top three foreign IT firms in India have 30% of their global workforce in the country, they report only 5% of their global revenues from India. In its 2010 annual report, Capgemini, for instance, says: ". the margin for Asia-Pacific is not representative of its activities, which mostly consist of internal subcontracting carried out in India."

Capgemini, initially, agreed to participate in the story, but did not, despite repeated reminders over email and phone. According to Nasscom, the association for the industry in India, there were about 750 captives in the country in 2009, employing 400,000 professionals and accounting for $10.6 billion in revenues.

These did work for their parents, either wholly or mostly. In addition, according to Som Mittal, president of Nasscom, there are 100 units of foreign IT companies, which are not captives. Together, they would be accounting for 30-35 % of India's software export revenues and 40% of employees.

The growing presence of captives and Indian subsidiaries of foreign IT firms has drawn the attention of tax authorities, who are looking at transfer-pricing transactions closely than ever before. Says a senior income tax official not wanting to be identified: "The issue is how the company apportions its cost and profit.

The department initiates action when it sees unfair apportionment to reduce tax liability in India." According to Rohan Phatarphekar, a reason cited by tax authorities to justify adjustments is higher profit margins of homegrown IT firms.

For example, in 2009-10, TCS recorded an operating margin of 45%, whereas IBM India reported a margin of 30%. Mittal says there is no reason why foreign IT and ITES firms should be targeted. "Till March 2011, these companies were covered under Section 10A and 10B of the Income Tax Act (which exempt income from taxes)," he says. "There is no motive for them to undervalue transactions."

And the case against

Even otherwise, tax experts say, given the nature of the work done by the respective parties, foreign IT companies can justify lower revenues. Hitender Mehta, partner with Vaish Associates Advocates, a law firm specialising in tax matters, says the Indian subsidiary of a foreign IT company takes limited risks.

"All the risk

related to the order, like pricing and delivery, is borne by the overseas unit," he says.

According to Vaish, the operations of, say, TCS and IBM India are not strictly comparable, as "these companies abroad bring the customers and it's their name that stands before the customers." IBM India, the wholly-owned subsidiary of IBM World Trade Corporation of USA, declined to respond to a questionnaire. This argument is corroborated by E Balaji, CEO of Mafoi, an HR firm.

"In the IT industry, client-facing jobs carry a premium compared to other functions like coding," he says. "Also consultants earn at least 15-25% more than normal IT professionals." By these arguments, foreign IT companies should get some leeway in transfer pricing. But the question remains: how much? Mittal says numbers of foreign information technology firms should not be benchmarked to those of top homegrown technology services firms.

"Tax authorities can't take the best performers and ask for a higher mark up," says Mittal. "They should look at the industry average." In 2009, Nasscom estimated an average operating margin of 15-16% for the industry.

"We comply with all international standards of transfer pricing," says Jim McAvoy, spokesman of Accenture, which is registered in Ireland, a low-tax regime. Its Indian arm posted revenues of Rs 5,270 crore in 2009, about 92% of which was related-party transactions. The company declined to give details of transfer-pricing methods adopted by it, or the mark up in contracts undertaken by Accenture India.

McAvoy says the revenue and profits of Accenture India cannot be compared with those of Indian IT companies, as their business models are different. "We are organised into 40 industry groups and these in turn are grouped into five operating groups, where our profit and loss resides," he says. "Also the global numbers are prepared under US GAAP (generally accepted accounting principles), whereas the Indian numbers are not US GAAP-compliant."

The three companies declined to reveal the quantum of adjustments under transfer pricing, if any, made by the tax department. Their latest annual reports show that IBM India had tax disputes of -- though not necessarily on account of transfer pricing -- Rs 94 crore and Capgemini Rs 9.4 crore; Accenture India did not disclose its figure. No further details were given.

The companies may also have paid some tax on these disputes. Typically, the department raises a tax demand once its transfer pricing officer determines undervaluation. "Companies can appeal, but they have to pay 50% of the demand raised," says Mittal.

"This (appeal) process takes time," adds Gandhi of Deloitte. "In some instances, the cases are pending for 7-10 years, adding to the uncertainty." Phatarphekar of KPMG says if the tax authorities sought a higher mark up, India would lose business. "Clients expect cost savings to be passed on when work is outsourced to India," he says.

Managing tax liability

Compared to home-grown firms, foreign IT firms with operations in India have greater scope to avoid taxes. And they are using it to good effect. Take Cognizant Technology Solutions, which is registered in the US.

It uses a provision in US tax laws to reduce its tax liabilities. The provision allows US-based firms not to pay tax on their non-US income if they declare they will not repatriate the money to the US. "We have indicated that since 2002," says Gordon Coburn, chief financial and operating officer of Cognizant. "The reinvestment policy will drive our future capital and acquisition expansion plans outside the US, including in India." In 2010, Cognizant incurred capital expenses of $180 million, globally.

In calendar 2010, Cognizant's tax incidence -- tax paid as a percentage of profit before tax -- was 10 percentage points lower than that of Infosys. Another active method of tax avoidance is share buyback, which the Indian subsidiaries of Accenture and Capgemini have used in recent years to potent effect.

It enables companies to take profits out of India; if they route it through a tax haven, as both these companies did, they pay zero tax on this transaction. For example, Accenture holds nearly 100% in Accenture India through a Mauritius-registered entity, Beaumont Development Centre Holdings. In the last five years, Accenture India has twice bought back shares, paying Rs 474 crore to Beaumont.

When asked why Accenture opted for a buyback when there was only one shareholder. and not dividend, McAvoy says: "It was more (tax) efficient." Long-term capital gains tax (holding period of above one year) in India is zero. And since India has a double taxation avoidance agreement with Mauritius, the company does not have to pay capital gains tax in the island nation too.

Had Accenture routed the profits as dividend, it would have had to pay dividend distribution tax of 16.9%, or Rs 80 crore. Even Capgemini India had a share buyback scheme in March 2011, where it extinguished 7% of its capital for Rs 366 crore; interestingly only one shareholder, Kanbay Asia (Mauritius), participated.

Foreign IT firms can make clever use of tax laws, and the tax arbitrage between nations, to minimise their tax liability in India. That said, the tax department seems to be checking at least one of those strategies: transfer pricing.